Perpetuals: Everything to Know
By Beluga Research October 30, 2023
- A cryptocurrency perpetual, also known as a "crypto perp" or "perpetual," is a derivative contract that allows a trader to speculate on the price of a cryptocurrency
- A perpetual does not have an expiration date and aims to replicate the spot market using a funding mechanism
- A perpetual allows a trader to leverage their position, which can amplify that party's profits and losses
- Trading perpetuals carries risks due to high leverage, market volatility and the potential for liquidation events
A cryptocurrency perpetual, also known as a "crypto perp" or "perpetual," is a derivative contract that allows a trader to speculate on the price of a cryptocurrency without owning the cryptocurrency directly. A trader who seeks to make a profit with perpetuals should gain an understanding of how such contracts work as well as how much they will risk. The point of signing a perpetual is to make money off the price movements (ups and downs) of a cryptocurrency without taking risks that are associated with storing, buying, selling or trading cryptocurrencies directly.
Direct contact with cryptocurrencies often requires a user to pay gas fees to engage in transactions. Engaging with a perpetual involves buying, selling or trading a digital contract. Perpetual contracts do not expire. They cost money to maintain.
A Brief History
Perpetual contracts originated in traditional financial markets with commodities and indices. They gained popularity when cryptocurrencies were introduced. BitMEX, a cryptocurrency exchange and derivative trading platform, was founded in 2014. It was one of the first platforms to offer cryptocurrency perpetual contracts. Since then, many more derivative trading platforms have been established. This has led to more perpetuals being offered and utilized.
Perpetuals: Everything to Know
How Perpetuals Work : Perpetuals use a funding mechanism to add or deduct fees from a user's account. The funding mechanism keeps the contract price close to the spot price. The spot price is the price at which an asset can be immediately bought or sold.
Funding rates are exchanged between long and short positions at regular intervals. A long position involves holding the asset for a long time in the hope that its value will rise. A short position involves holding the asset for a short term with the expectation that the asset's value will drop soon. If the contract trades at a premium to the spot price, long positions pay funding to short positions and vice versa. This mechanism incentivizes traders to align the contract price with the spot price.
Leverage Trading: Perpetuals allow traders to leverage their positions, multiplying their exposure to price movements without committing the full value. Leverage amplifies both profits and losses.
Funding Rates: Perpetuals utilize funding rates, which are expressed as annualized rates. This maintains the contract price in line with the spot price. The funding rate is calculated based on the contract price, spot price and prevailing interest rates.
Trading Strategies: Perpetuals offer various trading strategies, including directional trading based on price predictions and market-making by providing liquidity. Another trading strategy is arbitrage opportunities, which profit from price differences between contracts and spot markets. Arbitrage opportunities involve the simultaneous purchase and sale of the same asset in different markets. The idea is to take advantage of price differences.
Risks and Considerations: Trading perpetuals carries risks due to high leverage. Traders should manage risk through strategies like stop-loss orders. A stop-loss order is an order that an asset be bought or sold when it reaches a specified price, called the stop price. Market volatility can lead to liquidation events. Here positions are forcibly closed to prevent further losses.
- Find a reputable exchange that offers these contracts. Choose a platform with a strong track record, robust security measures and sufficient liquidity. Create an account and complete any necessary verification.
- Deposit funds into a trading account. The user should select popular cryptocurrencies like Bitcoin or Ethereum. Once the user has funded their account, they should explore the perpetuals market and select the contracts to trade.
- Understand leverage. Leverage allows traders to amplify their exposure to the underlying asset. For example, with 10x leverage, a trader controls a position ten times larger than their initial capital.
A funding mechanism rather than fixed expiration dates . With a perpetual, funding occurs periodically, usually every few hours. Funding is exchanged between long and short positions to maintain balance. Long positions pay funding to short positions if the perpetual's price is higher than the spot price. They do the opposite if the price is lower. This mechanism prevents large deviations between the perpetual and spot prices.
Use of a mark price to calculate traders' unrealized profit and loss (P&L). The mark price represents the fair value of the perpetual contract. It is derived from the contract's average price across multiple spot exchanges. Using the mark price ensures fair and transparent valuation. This reduces the potential for market manipulation.
Perpetuals often allow traders to adjust leverage and position size after opening a trade . The strategy of adjusting to manage risk is known as cross-margin trading. Traders can manage risk and capital more efficiently by adjusting leverage or adding funds to a position. Changes to leverage or position size can impact the liquidation price. This automatically closes a position to prevent further losses.
- Leverage: Perpetuals enable traders to control larger positions with less capital by using leverage. This amplifies potential profits if the trade goes favorably.
- 24/7 Trading: Perpetuals can be traded 24/7. In this way, they are unlike stocks in traditional markets, which can only be traded during specific hours. The 24-7 availability of perpetuals trading allows traders to react to market developments and opportunities at any time and location.
- Price Discovery: Perpetuals are traded on highly liquid exchanges, which attract numerous participants. The liquidity ensures efficient price discovery. This facilitates traders entering and exiting positions at fair market prices.
- Hedging: Perpetuals can be used as a hedging tool to protect against adverse price movements in the underlying asset. Traders can mitigate potential losses by taking positions opposite to their existing exposure.
- Funding Mechanism: Perpetuals employ a funding mechanism to align their price with the spot price of the underlying asset. This mechanism incentivizes traders to bring the contract price back in line with the spot price. In doing so, a trader reduces the risk of price manipulation.
- Price Volatility : Cryptocurrencies are known for their price volatility. This concern also affects perpetuals. High volatility in underlying assets leads to significant price swings in the contracts. This can result in substantial gains or losses for traders.
- Liquidation Risk: Leveraged trading carries the risk of liquidation. If the price moves against a leveraged position, traders may need to add more collateral or risk having their position forcibly closed by the exchange. A trader on the losing end of a transaction can suffer significant losses.
- Funding Costs: Perpetuals utilize a funding mechanism that involves periodic payments between long and short positions to maintain price alignment with the spot price. Traders holding positions for extended periods may incur significant funding costs. This reduces their profits.
- Counterparty Risk: Trading perpetuals exposes traders to counterparty risk. Since these contracts are traded on centralized exchanges, traders rely on the exchange to fulfill their contractual obligations. Exchange hacks or insolvency can pose challenges for traders in accessing their funds.
- Complex Trading Instrument: Perpetuals can be complex financial instruments, particularly for inexperienced traders. Understanding factors like funding rates, mark price and leverage requires a solid grasp of derivatives trading. Novice traders may struggle to navigate these complexities effectively. Education and outreach can help new users gain fluency with these types of contracts.